Big drama in corporate bonds could be closer than you think
Markets have gone back to the 1970s, when credit cycles were short and sharp
Corporate bonds can be dull. The period between 2004 and 2006, for example, was particularly tedious. Euro-denominated investment grade credit spreads — the extra yield over benchmark government bonds — were stuck in a narrow range of just 0.32 percentage points.
In 2020, many credit investors seem to think this unexciting pattern is back. Corporate bond spreads are already close to the floor of their trading range over the past 10 years, and there seems nothing on the horizon to make them widen. US and European growth is plodding along, and vigilant central banks are in the wings, ready to quash volatility as soon as it appears.
Yet such complacency is misplaced. Credit spreads are unlikely to move sideways for long, because cycles have become much more volatile since the global financial crisis.
In the 30 years before the 2008 crisis, a typical credit spread cycle lasted eight years. After widening for 18 months, spreads tended to tighten for two years, and then move sideways in a period of low volatility that could last up to five years.
In the past decade, however, cycles have shortened. The bear markets of 2007, 2011, 2015 and 2018 were swiftly followed by bull markets, while periods of sideways trading have become shorter.
To understand why cycles have contracted, investors need to go back further in history, to the dollar-denominated credit markets of the 1970s. Like Europe, the US also experienced long, drawn-out cycles in the 1980s and 1990s. In the 1970s, by contrast, US credit cycles were short and sharp — much like the cycles of the past 10 years.
Why have credit cycles returned to the patterns of the 1970s? Beards may be back, flares may be fashionable again, but the more important parallel between the two periods for investors lies in the level of government bond yields.
Nominal yields were high back then and have been low or even negative in the past decade; yet in both periods real yields were very low. Between 1973 and the end of 1979, real US bond yields — as measured by nominal 10-year yields, minus the annual inflation rate — averaged minus 0.3 per cent.
Between 1980 and 2010, real yields rose back to an average of 3.5 per cent, but over the last 10 years that average has dropped back to 0.6 per cent.
Real bond yields fell in both periods because of central banks. In the past decade, central banks depressed nominal yields below inflation rates by cutting short-term interest rates and purchasing bonds through quantitative easing. In the 1970s, governments did the same thing by capping nominal bond yields.
But why should low or negative real bond yields make credit spreads more volatile? There are two reasons. First, low real yields increase the propensity of companies to borrow. When nominal yields are at or close to the level of inflation, companies have to generate only very small real returns to cover their debt costs. Borrowing surges as a result. Although more leveraged balance sheets can be financed when yields are low, they do leave companies more vulnerable when the economy turns down.
At the same time, low real yields influence investor behaviour. Many of the buyers of bonds on both sides of the Atlantic are purchasing fixed-income assets to meet their liabilities. Insurance companies buy bonds to finance life insurance contracts, for example, while pension funds invest to provide retirement benefits. Both need positive real yields to generate the payments they have promised their investors. Therefore, as real yields in the government bond market fall, these investors move into riskier assets — like corporate bonds — to satisfy their needs.
Increased demand for borrowing from companies, along with increased demand for assets from investors, may look like a good match. But when supply and demand are finely balanced, small changes in the environment can lead to big changes in credit spreads. Investors know highly leveraged companies are vulnerable, so as soon as the outlook worsens, they head for the exit. Once the environment begins to improve, they flock back just as quickly, to get the extra yield that corporate bonds provide.
Instead of reducing the volatility of credit spreads, central bank policy is probably increasing it. The short credit spreads of the 1970s in the US returned to the longer, more normal cycles of the 1980s and 1990s only when Paul Volcker hiked interest rates and made US yields positive once more.
Global central banks still seem far from their “Volcker moment.” As a result, 2020 could be a much more exciting year for global credit markets than investors realise